2. Standard Costs: Direct Labor and Materials
Chapter Twelve
Standard Costs: Direct Labor and Materials

3. Outline of Chapter 12 Standard Costs: Direct Labor and Materials
Direct Labor and Materials Variances
Incentive Effects of Direct Labor and Materials Variances
Disposition of Standard Cost Variances
The Costs of Standard Costs

4. Connection to Other Chapters
Chapter 12 shows how standard costs and variances are used for decision control.
Chapter 4 discussed the decision control process.
Chapter 6 showed how budgets are used in decision control.

5. Standard Cost
Definition: The expected cost that is reasonably required to achieve a given objective under specified conditions.
Used for Decision Management:
Standards can be better predictors of future costs than actual past costs.
Can be used in product pricing, bidding, and outsourcing decisions.
Used for Decision Control:
Set performance expectations or benchmarks for the costs of products, processes, or sub-components.
Variances from standards get attention of managers.

6. Setting and Revising Standards
Setting standards depends on specialized knowledge.
Price standards from economic forecasts
Quantity standards from engineering studies
Choosing between tight and loose standards
Tight standards motivate higher performance (decision control).
Loose standards allow more discretion (decision management).
Standards are usually set once a year.
Frequent revision would reduce incentives to control costs.

7. Target Costing
Target costing is a technique used for new product planning.
1. Market planners begin with selling price required to achieve a desired market share.
2. Selling price Desired profit = Total target cost
3. Assign portion of total target costs to marketing, engineering, and manufacturing departments.
4. Redesign product and techniques to achieve target.

8. Purpose of Variances
Variances measure the difference between actual and standard costs.
Favorable (F) variance, if actual < standard
Unfavorable variance, if actual > standard
Decision control
Variances alert managers to deviations from plan.
Performance rewards may be based on minimizing variances.

9. Variance Computation
Symbols: T= Total; A = Actual; S = Standard; P = Price; Q = Quantity
Total Variance = Actual Cost minus Standard cost
TV = (AQ  AP) (SQ  SP)
= (AQ  AP) + [ - (SP AQ) + (SP  AQ)] - (SQ  SP)
= [(AQ  AP) - (SP  AQ)] + [(SP  AQ) - (SQ  SP)]
= [AQ  (AP - SP)] + [(AQ - SQ)  SP]
= PV QV
Total Variance = Price Variance Quantity Variance
See Self-Study problem.

10. Direct Labor Variance
Symbols: a = Actual; s = Standard; H = Hours; W = Wage rate per hour
Total Flexible budget Total
actual based on standard
cost actual input cost
(Ha  Wa) (Ha  Ws) (Hs  Ws)
|_______________________| |______________________|
[Ha  (Wa - Ws)] [(Ha - Hs)  Ws]
Wage variance Efficiency variance
|_________________________________________________|
[(Ha  Wa)  (Hs  Ws)]
Total labor variance
See Figure 12-1.

11. Interpreting Direct Labor Variance
Large variances in either direction indicate performance is not as planned, due to either poor planning, poor management, or random fluctuation.
Unfavorable wage variance
Workers were not available at lower rates
Unfavorable wage variance with favorable efficiency variance
higher-paid workers performed work more efficiently
Favorable wage variance with unfavorable efficiency variance
lower-paid workers performed work less efficiently

12. Direct Materials Variance - current use
In this case, no direct materials remain in ending inventories.
Total Flexible budget Total
actual based on standard
cost actual use cost
(Qa  Pa) (Qa  Ps) (Qs  Ps)
|_______________________| |____________________|
[Qa  (Pa - Ps)] [(Qa - Qs)  Ps]
Price variance Quantity variance
|______________________________________________|
[(Qa  Pa)  (Qs  Ps)]
Total materials variance
See Figure 12-2.

13. Direct Materials Variance - no current use
In this case, all purchased materials remain in ending inventories.
Recognize material purchase price variance at time of purchase rather than waiting until materials are used.
Qb = Actual quantity bought
Total Flexible budget
actual based on
cost actual purchased
(Qb  Pa) (Qb  Ps)
|_______________________|
[Qb  (Pa - Ps)]
Price variance
See Figure 12-3.

14. Direct Materials Variance - current and future use
Total actual Flexible budget based
cost on actual purchased
(Qb  Pa) (Qb  Ps)
|___________________________|
[Qb  (Pa - Ps)]
Price variance
Flexible budget based Total standard
on actual use cost
(Qa  Ps) (Qs  Ps)
|__________________________|
[(Qa - Qs)  Ps]
Quantity variance
Price variance recognized at time materials purchased.
Quantity variance recognized at time materials are used.

15. Timely Reporting of Materials Price Variance is Important!
Managers can act quickly to mitigate or capitalize on price changes.
For example, if a raw materials price rises, managers might want to use less of the more expensive material and more of the relatively less expensive material, if such a substitution is possible.
And/or management might want to raise the selling price for the final products.

16. Risk Reduction and Standard Costs
Risk reduction is a service individuals are willing to buy from financial markets.
Standard costs remove price and efficiency fluctuation from performance measures of downstream users.
Downstream users bear less risk because they know the standard costs they will be charged in the future.

17. Incentive Effects: Build Inventories
Rewarding purchasing managers for favorable direct materials price variances creates an incentive for them to buy large quantities when price discounts are offered for high-volume purchases.
Penalizing production managers for unfavorable labor efficiency variances encourages keeping labor busy producing more.
Mitigation of inventory building incentive
Charge purchasing department for cost of holding inventory.
Just-in-time (JIT) purchasing and production policies

18. Incentive Effects: Externalities
Purchasing externalities on production
Purchase cheaper substandard materials.
Purchase price variance is favorable.
Unusable material results in unfavorable material quantity variance.
Production externalities on purchasing
Short lead times on requisitions lead to higher purchase prices.
Requesting special orders for materials leads to higher prices.
See self-study problem, part b.

19. Incentive Effects: Discourage Cooperation
Evaluating performance evaluation on individual's variances
Emphasizes individual instead of team efforts
Reluctance to help others look good
Solution:
Base reward system on both individual and departmental (team) variances.
Too much weight on teamwork can lead to shirking (free-rider problem).

20. Incentive Effects: Mutual Monitoring
Method where managers or employees at the same level monitor each other’s performance
Noninsulating allocations encourage mutual monitoring (see Chapter 7)
Example when performance evaluation of both purchasing and production manager depends on both material price and quantity variances.
Purchasing manager wants to help production manager become more efficient in material usage.
Production manager wants to schedule requisitions to help purchasing manager buy materials at better prices.

21. Incentive Effects: Satisficing
Satisficing behavior: Managers have incentives to achieve standard but go no further.
Firm value would increase if managers attempted
continuous improvement beyond standard
innovate to meet competitive threats

22. Disposition of Standard Cost Variances
Alternatives for disposing (writing off) standard cost variances are similar to the alternatives for disposing of over/underabsorbed overhead (Chapter 9).
1. Writing all variances off to cost of goods sold (expense)
2. Allocating between costs of goods sold (expense) and work-in process and finished good inventory
3. Recalculating the cost of each job
The above alternatives are listed in order of increasing complexity.

23. Cost of Maintaining Standard Cost System
Standard cost systems require
Detailed standards for each labor and material input
Updating for technological and price changes
Time to investigate and explain variances
Standard cost systems are less likely to be used when
Direct labor cost is a small portion of total cost
Rapid change in production processes or new product introductions would require frequent revisions of standards